On April 10, 2007, the Internal Revenue Service and the U.S. Department of Treasury issued final regulations on the treatment of nonqualified deferred compensation plans and arrangements under Section 409A of the Internal Revenue Code.
On April 10, 2007, the Internal Revenue Service and the U.S. Department of Treasury issued final regulations on the treatment of nonqualified deferred compensation plans and arrangements under Section 409A of the Internal Revenue Code. Amounts considered nonqualified deferred compensation under Section 409A must comply with these requirements to be exempt from taxation as current income. The final regulations address how employers can identify nonqualified deferred compensation subject to section 409A and provide rules to help employers and employees comply.
The final regulations generally are effective January 1, 2008. Therefore, compliance with the final regulation's documentation requirements must be made by December 31, 2007. A “savings clause,” alone, i.e., a plan provision that says the plan is to be construed in accordance with Section 409A, will not be enough to override specific noncompliant terms or missing terms in the plan. Failure to comply with Section 409A could have significant tax ramifications for the service provider.
The IRS previously issued internal guidance under Section 409A and published a Notice of Proposed Regulations for public comment in 2005. The final regulations generally follow the proposed regulations, although there are some significant differences.
Following are some highlights of the final regulations:
Clarification of Written Plan Requirements: The final regulations provide that to satisfy the requirement that a plan be in writing, the document or documents constituting the plan must specify, at the time an amount is deferred, the amount to which the service provider has a right to be paid (or, in the case of an amount determinable under an objective, nondiscretionary formula, the terms of such formula), and the payment schedule or payment triggering events that will result in a payment of the amount. The plan must also include any limitations on deferral elections and distributions imposed by Section 409A.
Revisions to Plan Aggregation Rules: The final regulations provide for more categories of nonqualified deferred compensation plans for the purposes of analyzing when a compliance failure with regard to one plan should be treated as a compliance failure with regard to all other plans of a similar type.
Exceptions for Short-term Deferrals and Equity Rights: The final regulations generally adopt the short-term deferral rule contained in the proposed regulations, which excludes “short term deferrals” from Section 409A. However, they liberalize the standard under which a payment can be considered a short-term deferral even if it is delayed due to unforseeable events. The final regulations provide generally that payment may be delayed where the payment would jeopardize the ability of the service recipient to continue as a going concern.
Clarification of Issues Relating to Separation from Service: The proposed regulations provided that involuntary separation pay arrangements that provide certain limits as to time and amount of payment are excluded from Section 409A. The final regulations address when rights to compensation upon a separation from service for good reason may be treated the same as rights to compensation upon an involuntary termination. They also provide more detail on the application of Section 409A to severance arrangements and post-separation benefit reimbursements.
Stock Options and Stock Appreciation Rights: The final regulations generally adopt the provisions of the proposed regulations, which exclude statutory stock options and certain stock appreciation rights from Section 409A. However, the regulations update certain key definitions, such as service recipient stock. Also the regulations provide that the extension of the exercise period of a stock right will not be treated as an additional deferral feature for purposes of section 409A, where, at the time of the extension, the fair market value of the underlying stock does not exceed the exercise price (an "underwater" option).
Clarification of Exceptions to Anti-acceleration Prohibition: The final regulations provide that the addition of death, disability, or an unforeseeable emergency as a potentially earlier payment event is a permissible acceleration, thus including such a provision in a plan document would not be abusive.
At the same time the final regulations were published, the IRS also released Notice 2007-34, which provides guidance regarding the application of Section 409A to split-dollar life insurance arrangements.
The final regulations are extensive and the discussion above only highlights some of the more signification provisions of the final regulations. If you have any questions regarding the final regulations, please contact Stephen Zweig, szweig@fordharrison.com, 212-453-5906, or Udai Mori, umori@fordharrison.com, 212-453-5926, in our New York office, or any member of Ford & Harrison's Employee Benefits and Executive Compensation Group.